Central bank rate cut race

The last Central Bank review of 2023

Now we’re over the December central bank hump, let’s look at what happened and what changed

This is a follow up to my post a couple of weeks ago: The final furlong of 2023, where I discussed what could happen with central banks through the end of 2023 and into 2024.

The Fed

In my prior post, I said the Fed would likely give a strong push back on rate cut expectations. Boy, was that thinking blown out of the water. The Fed were trotting behind the pack in the rate cut race and then decided to get a wriggle on and steamed into the lead. The question is why?

Inflation has been coming down, though it’s been much slower of late. CPI is still in the 3%’s, core at 4%. The economy is chugging along. The jobs market is still doing well. There’s nothing to suggest the Fed should pivot, yet that’s the message they delivered. Why?

I’ve a few thoughts.

Firstly, volatility. CB’s don’t like volatile markets. Markets had already been playing the rate cut trade pre-FOMC, and getting fairly aggressive, so to suck out that vol, give the market what it wants, do it at an often volatile time of year (right on year-end). Rather than wait until the new year to drop the cut bomb, and the market reacting then, like it has now, give it the news now and it has the holidays to digest it all. Instead of throwing a lit match into a puddle of petrol in 2024, throw it in now while the fire is already burning, and there’s less effect.  

Secondly, liquidity. This is more Kman’s view that this move eases liquidity in markets and likely rules out the usual liquidity worries that can surface at this time of year. Ease conditions, and grease the wheels into 2024.

Thirdly, loosen conditions for the soft landing. Tight financial conditions will put the squeeze on the economy. The Fed are already seeing the signs. So, giving finances a bit more leash to play with helps with softening that economic risk. Yes, there’s inflation risk to that but overall economic strength is better than economic weakness so giving it a helping nudge is a positive. Plus, rates have come up very hard and very fast and with inflation falling (even if still a bit sticky), they no longer need a mallet to crack a nut. Also, remember we are going into an election year so what better than to give voters 401k’s a year-end stock market boost to kickstart that New Year feel good factor.

What does it mean for USD?

We had already come a long way in the rate cut expectations trade for the Fed but the real market pricing has only now kicked in. This confirmation should halt further increases to cut expectations, especially as some assets are pricing some 150bps of cuts compared to the Fed median of 75bps. We’ve had big moves in yields and USD but there’s a good chance we now ease off the gas and return to data trading to adjust the current level of expectations. That likely means we set up some new (lower) ranges for USD.

I would also warn of watching what happens in high carry pairs (think USDMXN). If rates are going to be coming down, and high rates have been what kept carry trades alive, a dovish shift naturally means that income is going to drop, which will force investors out. In something like USDMXN, there’s a large crowd and the exit door is usually small. Be wary of sharp squeezes. In a pair that’s seen USD used to buy into high yielding currencies, that means USD rallies rather than drops, as it would vs other pairs in a cut phase.

Keep an eye on yields also. Something like the 1yr yields is still at 4.91%, which is some 30bps above the Fed’s 4.6% median rate level for 2024. I’d side with what fixed income rate markets say about rates than interest rate markets any day.

 

The ECB

Lagarde came out with a strong pushback against the circling doves. In fact, she did what I expected Powell to do. She was strong for several reasons. That inflation might be going up again, in big part due to wage negotiations early in 2024, and that the job isn’t done on inflation. That rate cuts haven’t been up for discussion. All that outweighs the fact that the economy isn’t looking too great. Some lip service was paid to that fact in terms of how high and how long they keep rates up for, which, as ever, is data dependent.  All that came while inflation is at 2.4% and economies are weak. So, why can Lagarde be hawkish when the data suggests she should be as dovish as Powell?

One of the answers to that might be the level of interest rates. The ECB is only at 4.50% (4.0% depo rate), so well behind the Fed. Even if they do nothing, and the Fed cuts their 75bps in 2024, the Fed will still be higher in a year’s time. Not having rates as high means there is less need to cut faster back to a neutral level. The ECB never used the mallet to crack the nut in the first place. It means they can put time on their side and take a smoother approach.

The big risk I see for the ECB in 2024 is the potential for an inflation overshoot the wrong way (back through their target). If that happens over the next few months, instead of the rising inflation they expect, they might be forced to bring forward that rate cut talk they’re not entertaining now.

For EUR.

It’s going to keep EUR pairs on the front foot, especially against USD. Against others, that’s a bit less clear and you have to match off what’s happening in the Eurozone vs others. We can’t also ignore that the Euro is the second most traded currency, so by weight alone, it’s going to be favoured against others, even those who have CB’s that may still be hiking. Like USD though, in the short-term, look for the market to continue to reprice the latest ECB stance before maybe settling down into some different range areas.

 

The BOE

This one went as expected in my prior post. No signs of cuts on the table, and still plenty of worries over inflation and high wages keeping hikes on the table. The BOE was always going to be the horse lagging behind in the cut race. But, there is still a large risk that the economic pain picks up that might force the BOE into being more dovish. This will be something that needs watching into early 2024, while the Fed might have sticky inflation but a fairly decent economy, the UK is showing flat to negative growth, and the UK doesn’t usually do neutral. Things are either good or shite, not in between.

For GBP.

The BOE has kept the pound in happy mode. While it won’t take much bad news in the data to knock it off its perch, it still might be the better of a bad bunch, if only due to what other currencies are doing. For something like EURGBP, that weight differential for EUR I spoke about above, might mean a non-dovish ECB outweighs a non-dovish BOE. But, remember the volatility difference between EURUSD and GBPUSD (where cable can move more than EURUSD when they’re both moving on the USD side). I don’t expect any new range breaks in this one while the BOE and ECB are roughly inline on their monetary policy positions. If that changes, obviously that changes things for EURGBP. Until then, play the same old ranges.

All that leaves us is the good old BOJ next week. We’ve had fun and games there too since my prior post. Ueda issued some comments that were taken hawkishly, which collapsed yen pairs, and then the cleaners got sent out to tidy things up and claim misunderstandings and misinterpretations. Expectations ramped up for the end of tightening, even for the meeting next week but they’ve eased since. I think Ueda might do a job of “clarifying” his prior comments and making sure the market keeps its feet on the ground regarding hawkish expectations. So, an unchanged meeting with plenty of “not there yet” tones and can-kicking to the wage negotiations next spring. For trading it, I’m still looking to hit any decent rally in USDJPY to add to a short I’ve started over the FOMC.